3 Myths of Investing: If You Know These, You’re Ahead of Most Investors (Part 1)

Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking money and investing, retirement planning, financial planning, helping you understand how investment markets work and how the planning and investing process works in general.

Because typically, we get information from people trying to sell us stuff. And it may not necessarily be what you need to be doing, but there are very distinctly different ways of actually selling mutual funds.

Marketing Investments

I was talking about this to somebody this week, and let me just kind of hit something right here. We’re talking about marketing of investments, the idea of getting people to invest. If you’re a financial planner — let me do it from that perspective — or you’re a mutual fund company or you’re a large investment firm, how do things get marketed to the general public?

Well, number one, one of the things that they’ll do is this: They’ll often look at the emotional aspect of it. “Hey, your dreams are important to us,” and that type of thing.

But how do we get somebody to look at a company, a fund company, and how do we get them to invest in a mutual fund? Well, there are several different ways.

Number one, it has historically been the case that we use past performance. We look at track record. We go, “Hey, look, this is how we’ve done.”

I saw a commercial this morning, “130 years in business, getting you through this and that and all of these different ups and downs.” It wasn’t quite that long, but it was just a really long period of time. “Getting you through the ups and downs of markets, and navigating all of the circumstances and the just insane changes that have happened,” those weren’t the words that they used, “over the past hundred years” or whatever.

And I thought, Well, what’s really funny is the people running the company now were not the people that navigated the Great Depression. It’s not the people that navigated World War II. 

It’s not the same people. It’s a totally different group of people. 

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How do I know that the group that is running it now will have any success whatsoever? 

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So it’s just kind of funny, the way I look at the advertising and marketing. But a lot of times, what they’ll do is — and this was my experience when I was working for a big investment firm, and I’ve worked for several of them — they’ll say, “Hey, this fund that had the best return, these guys are really, really on top of what’s happening in the economy right now. I think you ought to put your clients with these particular funds.” And they’re using the historic return of the fund and implying that it’s going to continue into the future.

Looking at the S&P 500

Now, I was having a conversation this week with a client friend of mine in another state, and we got into a conversation about employees at the company that he runs. It was funny, because he said, “There was so much pressure over the past couple of years.” And I’m paraphrasing what he said.

“There was so much pressure. The other people would come up and say, ‘Why don’t we just put everything in the S&P 500? Can’t we just have more money in that? Why don’t I just do that?

“I could buy this fund over here, and it’d be easy. Just do that, put it all there.’”

And the point that I made to him, I said, “Yeah, and it’s interesting, you look at international small companies last year, the value companies, and they were up over 50%. I mean, the S&P paled in comparison to that.”

So far this year, as I speak, you’re looking at how the S&P is flat, compared to every other asset category pretty much being way, way greater return-wise. And it’s just you can go through periods of time, and this is nothing.

I mean, you look at this. I’m just talking about last year and this year so far.

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But you can look at 20-year periods where the S&P does nothing.

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I remember back when I first started and opened this company, I went back to the library, and I was looking for articles just throughout history. I went back to the 1930s, and I was making the point of looking for articles that were talking about what the stock market was doing, what investors were doing.

It was so funny, as I went through history, how people would just change from one area that they were really enthralled with when it came to investing, switching over to a completely different area. People were talking about gold in the late 1970s.

And as I’ve often said, “It’s not an investment because it doesn’t have any cost or capital.” But they were talking about gold and silver and diamonds and collectibles and all of those things.

And all of a sudden, when the ’80s rolled around and you had international just take off like crazy, a lot of people didn’t own it because nobody was talking about it. So what ended up doing well over the next 10-year period wasn’t even talked about at all in the previous 10-year period, because it wasn’t on the radar screen.

And then you go look at the technology revolution in the 1990s. Well, nobody was really talking about technology in the early ’90s.

Wasn’t really until about 1998, 1999 that I started hearing a lot of talk about technology and having that in your investment portfolio. And it was after that area had done so well. And then go on, go forward, fast-forward in the future, you had the dead decade where large U.S. companies did nothing at all.

Investing Myths

So there are myths of investing that I often talk about here, and I think it’s really important to just get what they are. One of them is, and perpetually, I’ve often thought, This is going to die. It’s going to die a terrible death. And at some point, nobody’s going to do this anymore.

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It’s the myth of stock selection, and trying to figure out which companies are going to be the ones that are going to be the winners going forward.

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And as I’ve often talked about here, the companies that came up with some of the great technologies of the past, like digital cameras, cell phones, those types of things, are not the companies that really benefited from those inventions and those advancements. That wasn’t what did well going forward.

It was completely different areas and different companies making those same products, like the Motorola cell phone. Nobody uses them anymore, right? We have anything but. As far as the companies that are designing and building and selling those phones now, Motorola isn’t amongst that group.

And then you have digital cameras. Even though Kodak came up with a digital camera, we don’t go out and buy Kodak digital cameras.

I mean, that’d be the last thing on our minds. You know, Sony is really big, Canon is really big, Nikon. It’s just totally different companies.

So, trying to pick stocks that we think are going to do well is something that investment companies will do. And some of the big asset managers, this one says, “If you have a portfolio of over a million dollars, the strategies you need to be using now will get you in and using those strategies.”

And I’m like, “Yeah, as if those strategies don’t work if you have 900,000.” That’s a gimmick. But they’re implying that you really can’t use their portfolios very well unless you have more than that.

Then when you look at their portfolios, they’re actually using individual stocks, and they’ll have individual companies in there. And they’ll only have a handful, compared to what I would consider a really diversified portfolio. Because even with a million dollars, getting a level of diversification that we really want at the lowest trading costs and being able to buy in larger blocks, it’s just not possible.

And then also what happens is with those individual companies, they’ll say, “Hey, we’re building you your own mutual fund.” Well shoot, I can build an S&P 500 mutual fund or buy an S&P 500 mutual fund that has 500 companies in it, and be paying four basis points, or 4% of 1%. It’s not that big of a deal.

And I’m going to get to that myth a little bit later, the myth about costs, because costs are now being used to manipulate investors. And I want to talk a little bit about that as we go on.

Another myth is using history and past performance. Another myth is trying to figure out where the market’s going to go, what areas of the market — that’s market timing.

When we choose companies we think are going to do well, we’re looking around and going, “I really like this company. I like what they’re doing. I like the products that they have. I like where they’re going and what their plans for the future are, and the marketing plans for the future, and where technology is likely to take them.”

Managing a Portfolio Based on Predictions

Well, one of the things I like to point out is the SPIVA, S-P-I-V-A, website. And if you look at all domestic funds, looking at the period in time from January of 2004 through the end of December of 2023, you have 96.83% of domestic funds underperforming their benchmarks.

You’re looking at mid-cap funds, 90%. You’re looking at multi-cap funds, 95.96%. You’re looking at real estate funds for 82%. Large-cap funds, 96% of the professionals underperformed that area of the market.

If we’re looking at small companies, even small companies, small value, it’s 84.54%. Small core, 93%. It’s abysmally bad. It’s almost a joke that they’re underperforming on a routine basis.

So if you have an investment manager that’s buying individual stocks, and they’re managing the portfolio based on which companies they think are going to do better in the future, or if you’re doing it, the odds are stacked against you that this is going to be a successful way of managing money. It just doesn’t work really well.

Matter of fact, there was an article talking about hedge fund managers. They found that hedge fund geniuses got beaten by monkeys again and again. That was an article that was in The Wall Street Journal, pointing out that this is not a really great way of managing money.

Now, hedge funds are funds that wealthy people are supposed to be able to invest in. And you think, Well, because they’re wealthy, they’re going to be more sophisticated, they’re going to get better investments than you and I. And what you’re seeing is they’re not.

I mean, monkeys throwing darts at stock tables. They have a picture of two monkeys playing on a computer, and you think, Oh wow, that’s kind of embarrassing.

But the marketing sounds great. “If you have a million or more, if you have 500,000 or more, you have 250,000,” or whatever.

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You’ll hear that kind of thing, and you think, Oh, sophisticated. These people must be really, really good. No, they’re really good at marketing.

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And then you have John Stossel throwing darts at the stock tables. He’s done that for years and is just making fools of the professional investment managers.

Portfolio Design

So one of the things I’m often talking about is making sure I’m capturing market returns. If we look at large U.S. stocks, the S&P 500 does work fairly well for that area. Now, if we’re looking at value companies, Russell 1000 Value, value indexes do okay.

They’re a bit expensive, and it’s not so much the expense that’s the biggest issue. The bigger issue is portfolio design.

When we talk about portfolio design, if I want to keep the expenses extremely low as a mutual fund company to attract the investor that wants a bargain, that wants to think that they’re getting one over on The Man, so to speak, what I will do is I will keep the management fees very low by cap-weighting an investment portfolio. In other words, I will weight it based on the capitalization of the company.

So if I have one company that’s twice the size of another company, I’ll have twice as much money in the bigger company. If I have another company that’s three times the size of another company, in that company, you’ll have three times the amount of money.

So, what is getting more of your investment dollar? The bigger companies. Well, “value” by definition should be smaller companies. You’re talking about companies whose price is lower compared to their sales, compared to their earnings. And more importantly, based on their book value, the assets of the company.

So by definition, I should own smaller companies. But the index is going to overweight bigger companies. Thus, I am ending up losing returns historically by doing that type of investing.

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Indexing is very attractive because it does better than the professionals. But I’ve already established the professionals are not getting it done.

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They’re doing a poor, poor job. But it has the appeal that it’s really low cost, and it really has the appeal for a do-it-yourself investor.

And the do-it-yourself investor doesn’t realize these things. They don’t think about, you’ll have mutual funds now indexing that have zero management fees. And you go, “Wow, free is for me.”

But they’re doing that, they’re getting you a 0% management fee, how? Are they running a charity? No, there are a lot of things that mutual funds can do to actually make money on your money off to the side. And they do that and keep the revenue for themselves.

Overcoming Stock Picking With Investing

Well, there are some fund companies, the ones that I would want to use, that actually give that revenue back to the end investor. And you may not even know that, because a do-it-yourself investor isn’t going to be focused on that type of thing.

That’s one of the myths of investing is that, stock picking. And we think, Okay, we overcome stock picking with indexing.

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Well, we’ve run into another problem with indexing, especially if I’m looking at a small index fund: It’s going to overweight what? Big small companies.

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So what I end up with is a portfolio with lower long-term expected returns. And I have a portfolio that looks more like my large-cap portfolio, so I lose some diversification benefits as well.

Because they’re owning the bigger small companies. If I have a large company stock fund and then I get a small-cap fund that’s indexed, I have more movement.

And you see that in the TSP, Thrift Savings Plan, that the government employees have. They have a completion index is what their small-cap index is. Well, their small-cap, it’s not really small, it’s mid-cap, which looks more like large-cap. So you see that a lot of what’s happening is we are falling prey to the marketing.

And what I want to do is I’m going to spend a little bit of time on another myth right now. After this, I’m going to take a quick break, and I’m going to come back and I’m going to talk about track record, because this is what’s really getting people into trouble right now. My business owner was dealing with an employee, and I want to walk through this very specifically to help you understand where track record in a couple areas, in two very distinct areas, can get you in a huge amount of trouble.

“We Do Better When You Do Better” Marketing

Okay, so I’m just running through a couple myths of investing. A couple of basic types of things. We talk a little bit about trying to pick individual companies, and I see this all the time with big mutual funds.

There’s this thing that you’ll hear, “We do better when you do better,” that type of marketing. And there’s a part of me that goes, yeah, that is kind of a good way of doing things. But there are two very distinctly different ways of approaching this.

“We do better if you do better.” Well, number one, you can use track record. If you haven’t attracted an investor to your portfolio or attracted them to your business as an investment manager, you’re not going to do better anyway because you’re not going to get them to put their money with you. Let’s just face it.

So, what fund companies will do, and what investment managers will do, is they’ll use track record, but in some cases, they just use that phrase, “You do better if we do better,” and blah, blah, blah, blah. Then, what they get in front of you in the sales process, they talk about “If you own this fund and if you’d own this fund, you’d own that thing. If you had done this over the past 10 years, here’s what your return would’ve been versus what you got right now” and blah, blah, blah.

Then what will happen is you’ll go, Wow, I’ve got to do whatever you’re saying. And there was one company that I remember, somebody giving me a book. They had actually met with this investment advisor, and it was a really nice book and it was showing all the mutual funds that they said that this guy should own.

And I was looking through it and going, Wow, did they own these during this period of time? And when I read the fine print, no, they did not own these funds during the period of time in question, but that’s what they were recommending now.

Then what I did is a couple years later, I just watched what they recommended. Now, this guy did not go with this fund company, but I just kept the book that he gave me because he gave me their presentation book. And I looked a couple years later to see how the funds had done that they had recommended.

And the best performance, the best performance was 3% under the area of the market that the fund had been investing in. And it went all the way up to over 10% under performance, and this is per year. It was abysmally bad. It was really, really bad.

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So, the investment advisory firm attracted the money through past performance of things that they didn’t even own, that they weren’t even investing in.

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But that’s how they market themselves, “You do better if we do better,” or, “We do better if you do better,” I guess put it that way. So, it sounded really, really good.

Educating People on Market Segments

Now, the other way of doing this, and this is the way I approach it, is educating people on market segments and helping them understand how investing works. Not so they know everything I know, but just simply understand a little bit of how this stuff works. Because, quite frankly, when I put a portfolio together, I will put somebody in something that would have a track record of very low, maybe.

And I like to go back to when I first opened the company in the year 2000, late 1999, early 2000. And I remember saying, “Okay, we’re going to have, because the academic research says we ought to have international small companies in value in particular in the investment portfolio.”

Well, the five-year track record of that area was zero and nobody was talking about it. Nobody had any interest in that whatsoever. Well, over the next 10 years, it quadrupled in value and you look back and go, Wow, it would’ve been nice to have owned it during that period of time.

Well, what happened with the clients I was working with was I said, “This is the reason we would own this. These companies have to pay to use your money just like anybody else. It is just part of a diversified portfolio. And quite frankly, when you put different areas of the market together, the reason you’re doing it is because they don’t move with each other.

“One may have skyrocketed while another didn’t do much of anything, and that’s okay. It’s all right because the thing that didn’t do well over the past five years, may be the very best thing going forward.”

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But track record is something that is used because it’s easy to sell to people.

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If you look at the top 30 equity funds, you go back from 2004 to 2013, the very top equity funds out there had an 18% return. You go, Wow, these people are really good, 18% per year return. 

The market over the time, the whole market wishes, we would represent the CRSP, Center for Research in Securities Prices at the University of Chicago, one through 10 had about a 10.14% return. Well, that’s significantly less versus the 18.

Well, what happened going forward? The top funds, the very best funds of the first period of time, those 30 funds had a 7% return going forward, versus almost 13 for the Center for Research in Securities Prices one through 10.

So, you look at that and go, Wow, that’s about a 5% per year difference, and that’s huge. It’s a huge amount of difference in return over that period of time.

Investing Based on Trends

But you’ll see the magazines out there, and the magazines, they’ll put out where to invest in 2024, where to invest 2025, money moves to make now. And when you go through these magazines, you’ll typically see a listing of all the funds that had the best track record recently, and investment advisors do this as well. You may not know that they’re doing it because they have a tendency to talk a good game as far as how they’ve chosen things and the intellect that went behind it, and it will sound something like this.

Well, as investors look ahead, what’s going on? The bull market is embarking on a second year, and we’re really looking at what is likely to happen. And financials look like they’re going to be pretty good this year, and Staples might have a decent year this year, and energy because of what’s happening over in blah, blah, blah, may be doing well. And it will sound really good, that you ought to invest in these areas because of the trends that are happening.

Another thing that they’ll do is this. This is something I was taught to do when I was working for an investment firm.

They’ll use rating services. “This is a four-star fund, five-star fund.” Well, one of the things that I like to point out is there was a great article entitled “The Morningstar Mirage.”

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They were showing how the five-star ratings, the funds with the four- and five-star ratings, how they just didn’t repeat.

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They went on to underperform in the future. Well, why did they use this in marketing? It’s because it works from a marketing standpoint.

The Wall Street Journal had a study that they had done. They found that 72% of mutual fund inflows went to four- and five-star funds.

The Problem in the Investing Industry

Now, if you knew as an investment manager that in order to get people’s business, you really had to recommend highly-rated funds in order to actually have a story that people would go, “Yeah, I want that.” Well, you’d be hard-pressed not to market based on past performance.

And that is the problem in the investing industry. It is a problem with the investment managers, investment advisors, and mutual fund companies.

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They know in order to get your attention, they’ve got to show past performance that is enticing.

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Jonathan Clements from The Wall Street Journal once wrote, “I believe the search for top performing stock funds is an intellectually discredited exercise that will come to be viewed as one of the great financial follies of the late 20th century.” He was a writer I followed for years, and he was so right about that, that it was a folly, but he was wrong that people would start to recognize it as a folly and walk away from it, because it is still used so often.

What I’m going to do is after this, I’m going to come back and I’m going to walk you through just a piece of history just so you can see what I’m talking about — or hear would have been a more appropriate word — what I’m talking about right here regarding this issue of using past performance and how things change and how drastically. It’s really eye-opening when you see how drastically they can change from one period to the next.

And this makes a big difference. Let’s say I have a 2% difference in my return in my portfolio, you think, Oh, 2% is nothing. You take that over a 23-year period, you’re talking about the difference between living well and maybe just barely getting by or struggling. A couple percentage points difference in return can make a big, big difference over time.

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.